Economics : Is there a housing bubble?
New York: July 13, 2004
By John R. Stephenson

For most of us, home ownership is the cornerstone of a sound financial plan. It is, without a doubt, the most significant purchase most of us make in our lives and with interest rates so low, many of us have been rushing to become homeowners. Many market watchers are of the opinion that house prices are unlike other asset classes since they do not trade on a national market but rather are local in nature. By being a local market, they are more likely to be driven by the forces of local supply and demand rather than by a speculative bubble. The Chairman of the Federal Reserve, Alan Greenspan, has also indicated that the high cost of buying and selling houses tends to dampen speculation.

There appears to be some truth to the argument that housing is indeed a local market. Most of the gains in real estate nationally have been along the coasts of the country whereas in the interior of the country, strong supply growth (homebuilding) has managed to keep prices down. As well, many pundits argue that a median-priced house rings in at $184,000 and when compared with a median family income level of $55,000, these houses are very affordable — at least at today's rates.

But herein lies the problem. Interest rates are starting to ratchet up. Ordinarily, a rise in interest rates would be of some concern, but today, we have homeowners even more stretched financially than at any time in the past. Across the board, the percentage of homeowners' equity (the non-debt portion of the financing) has fallen from 72% in 1986 to 55% today, making homeowners vulnerable to a rise in interest rates. How vulnerable? If mortgage rates were to increase one percent and a 30-year fixed-rate mortgage were to go from 6.2% to 7.2%, the average house price would have to fall by some 11% just to keep the average mortgage payment the same. By the same token, if interests rates were to rise to 8%, then to keep mortgage payments constant, house prices would have to fall by 20%. This is particularly worrisome when you consider that the average American saves about 3.4% of his/her disposable income.

More and more Americans have been attracted to the housing market particularly after the implosion in 2000 of the stock market. With many of the coastal regions experiencing strong growth in housing prices starting around 2000, one could argue that speculative activity has just switched from the stock market to the housing market — at least in the coastal US. One thing is certain, there has been a rush of first time buyers to the housing market that has been attracted by low interest rates. Many of these homebuyers have squeezed into the real estate market by taking advantage of the low rates offered by adjustable rate mortgages. Although this form of financing is attractive when interest rates are falling, it can be deadly when rates are rising. From March of this year to today, the increase in rates has affected the annual borrowing costs of new buyers with adjustable rate mortgages by some 25% already.

Over time, house prices have moved in lock step with incomes. Obviously, it seems unlikely that house prices can continue to advance significantly faster than household incomes indefinitely. Economists have tracked the ratio of house prices to household income and currently the ratio stands at 3.4 — a record and some 19% above the 1975-2000 average. To bring the ratio back to historic norms, household income would need to shoot up 24% or house prices would have to fall 19% — a difficult proposition.

In order to keep house prices aloft, incomes will need to rise and interest rates will need to remain low — an unlikely proposition. If the economy improves, then interest rates will rise, if it worsens, then incomes will stagnate or decline. In either case, the catch 22 of house prices is likely unsustainable which should result in a fall in prices accompanied with a slowdown in spending on other consumer goods.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article